What should we be doing with the banks?

The current round of bank-bashing means one thing: Our politicians and business leaders have completely missed the big picture lessons from the global financial crisis. So, while the rest of the world is tackling financial regulation, Australia has its head in the sand.

The big lesson from the GFC is simple. The Australian government will underwrite deposit holders, bond holders and, at least in part, equity holders in our major banks. If you have a deposit in one of our big-four banks or in our key second-tier banks, the Australian government has shown by its actions that it will protect your money. It will not let your bank fail. If necessary, it will actively seek out a buyer for the bank, as in the case of Bankwest.

This lesson is important because it turns our pre-GFC bank regulation on its head. Australia was meant to be one of the few OECD countries without deposit insurance. Post-GFC we know that is wrong. Like it or not, it is politically impossible for the federal government to let a major Australian bank fail.

Why does this matter? If the government insures the banks then it needs to start acting like an insurance company. The first step is to make the insurance explicit. The government needs to clearly state what assets it insures. It also needs to charge the banks an appropriate insurance premium. This is not a bank tax. It simply recognises that the government is underwriting the banks. As individuals we expect to pay for car and home insurance. The banks need to pay for the asset insurance provided by the federal government.

Second, the government needs to recognise that bank insurance is not like normal insurance. The bank cannot refuse the insurance – because the government cannot credibly let the bank fail. Similarly, the government cannot invalidate the insurance if a bank acts irresponsibly. Politically, the government will have to step in even if a bank’s failure is the result of excessive risk taking and stupidity by bank management. So as an insurer, the government needs to explicitly limit the range of activities that banks can undertake.

This is more than capital adequacy requirements. As insurer, the government must restrict the banks from activities that create too much risk. For example, banks may be required to divest their fund management activities if these create too much risk from the government’s perspective. Of course, someone else can take up these activities. But whoever takes on these activities must be completely separate from the banks and it must be clear that they are not insured. The government will protect bank depositors, not investors in non-bank financial institutions.

Third, we need to carefully design the new insurance-based bank regulation. We have a lot of experience with industry regulation in Australia. Let’s apply it to the banks. We need a Son-of-Wallis inquiry to work through our banking rules and recommend appropriate changes. We will not get perfect regulation but we can design clear regulation that is not subject to gaming.

The banks will not like these changes. They have been getting free insurance for years. Why would they now want to pay for it? They have had a government insurer who has placed too little restriction on their activities. Why would they want to face (actuarially sensible) restrictions now?

The banks will argue that changing the financial rules and limiting their activities will make them worse off. Yes! They will. The banks have had a free ride through the government implicitly underwriting their activities, so obviously they will be worse off by having to pay for an insurance service that they previously got for free.

The banks will argue that ‘others’ will be able to compete in markets that they cannot compete in. Of course! But the ‘others’ better not have an implicit (or explicit) government guarantee.

The banks will argue that money will flow to these ‘others’ to avoid the regulations. Correct! If people wish to place their money in a riskier, non-insured option then that will occur. The government needs to make sure it can credibly commit not to underwrite these ‘others’. But given that commitment, if consumers want to take the risky alternative they can do so. But the banks cannot – because the government cannot credibly let the banks go bust.

The banks will argue that these new regulations reverse the changes of the 1980s and 1990s. Absolutely! The deregulation of the 1980s and 1990s assumed that the government did not insure the banks. We now know that assumption was wrong.

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5 Responses to "What should we be doing with the banks?"

There was never any explicit guarantee of the banks and their deposits but if I remember correctly during the last recession of 90-91, the then Treasurer, Keating, forced the takeover/handover of the insolvent Vic State Bank by the C’wealth bank. (A state-owned savings bank with merchant banking arm doing the state’s bidding…) And let’s not forget the Pyramid Building Society debacle where the Vic State government had the public paying extra petrol tax to subsidize depositer’s (non)assets.

On that basis, there has been a precedent for governments guaranteeing the banks (if not all deposit and lending institutions), so I don’t think the recent occurence of the GFC is a novelty in this respect.

As you state perhaps it’s time to make banking insurance transparent. Will it imply that all depositers should be forced to have compulsory deposit insurance much like Third Party Vehicle insurance? (The banks will pass along the charges anyhow.)

Another thought – would an explicit guarantee make the adverse selection problem better or worse? Maybe the Swedish banking crisis (90’s) solution of wiping out equity would concentrate minds on risk over the business cycle (- banking managers tend to hold significant stakes)?

About that last part, instead of forcing this upon these selected companies (big 4 banks), why doesn’t the government just create their own government owned bank, that they insure, and provide deposit insurance for.

Then again I’m not sure how the government could provide these assurances that your money is safe, because the value of money is controlled by the market and the government cannot control the market without creating a socialist society (ps. I know almost nothing about Economics or Politics).

What I mean is for your money to still have value you expect to be able to buy some bread for $2, but the government cannot force people selling bread to sell it for $2, they could charge you $100, so the government cannot really guarantee the value of your money without itself creating the bread to sell to you for $2, and this is essentially a socialist society.

@Andrew: Apart from the obvious efficiency and political interference arguments against the government directly getting into the banking business, generally speaking creating a new government owned bank wouldn’t address the underlying issue that the big four banks have an implicit guarantee. It’s clear from the GFC that it’s not credible for the government not to intervene when any of the big banks get into trouble (even if the govt. says otherwise by creating a new bank with explicit guarantees).
Hence it’s a bit disappointing that both sides of politics seem more interested in scoring cheap political points in getting into a debate about banking competition when the important policy issue should be about how to address the distorting behaviour that the implicit guarantee creates in the banking sector.

Whilst the circumstances were such during the GFC that led to the guarantees coming into effect, I do agree that the govt needs to start charging for the “insurance”. What is concerning me more now is the govt wanting to back the RMBS market. It clearly didn’t work in the US, but somehow our govt has the view that it will work here. They need to review the lessons from Freddie Mac and Fannie Mae.

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